Quality Growth in Perpetuality

Recent US consumer and input price numbers from around the world have given investors cause for optimism. This was reflected in a sharp rally in stock markets and, more importantly for long-term investors in Quality Growth businesses, in bond markets, during the month under review. This burst of market energy was accompanied by the usual doomsters who warn investors against exaggerated optimism as they expected another downward lurch in share prices, as well as in bond prices.

Some basic stock market rules appear to have been forgotten or ignored for convenience when listening to the perennial doomsters. Foremost among these is the role of stock markets. This consists of placing a value, today, on the corporate earnings of tomorrow for stock market-listed businesses. Both “today” and “tomorrow” have different meanings at different times, but the broad rule has stood the test of many years of history. It is also highly logical.

When markets reached their highs and thence embarked upon their precipitous decline at the start of this year, accompanied by rising interest rates courtesy of a number of influences, both political and economic, they sent two broad signals to investors. These signals focused firstly on the expectation of reduced corporate profits in the economic period going forward; and secondly, in aggregate, on the expected economic contraction otherwise known as a recession.

What is well known is that all recessions have been preceded by stock market declines while not all stock market declines were followed by recessions. This makes for heated debate, as is going on right now.

It is worth looking more closely at the arguments brought forward by the doomsters. Note, also, that many of these doomsters have been predicting somewhere between a bear market in share prices and a financial Armageddon in the economy resulting from the long period of what they call the “abnormal” price of money. This policy was often described as “asinine”. It was inevitably sowing the seeds of its own destruction coupled with that of the economy. These doomsters have had to wait for many years before their negative expectations came to pass. The logical question arises of whether they represent the stopped clock (or blind chicken) syndrome or whether they have a point – and are right at last.

One leading argument has it that the recent inflation numbers are illusory as the taming of inflation requires a recession. Time will tell whether this is true but it is plain that certain countries or economic blocs have already begun their recession (at the forefront of this lies the UK, not least because of the Brexit effects, but close behind lie China and Japan. These are no small economies and are experiencing disinflation or economic contraction).

For these doomsters a disinflationary down cycle requires hard evidence of economic contraction. Where 2022 was a difficult year for keeping inflation under control, 2023 will be even worse as inflation has yet to plateau around the world. Recent encouraging numbers in the US are an aberration, not a new trend. When inflation reaches the plateau, central banks will need to decide whether to tolerate the new inflation plateau or whether to launch a recession through a continuation of rising interest rates. Interestingly, these doomsters make no comment regarding the sharp fall in the price of energy, raw materials and other commodities over the last few months. Logic would have it that this is bound, sooner or later, to produce inflation numbers whose comparison with past numbers will likely be of a kinder nature.

If one can broadly accept that rampant inflation is bound to subside sooner than later, and once more produce an era of disinflation, the next question is whether this disinflation era will be accompanied by boom or bust. Where the pre-pandemic economic period can safely be described as a disinflationary boom that caused share and bond prices to rise, the months and years to come will suffer a disinflationary bust, no doubt accompanied by a decline in output and further falls in share prices; but rises in bond prices. This is the base scenario of many doomsters.

Self-styled investors who place bets on where the expected momentum will lie in the months ahead will be reflecting on how to make strong performances from share, bond, or other prices irrespective of the underlying businesses where these exist. That is the nature of financial markets.

For Quality Growth investors, the central issue is whether their portfolio can withstand whatever background is served up – one of continued rampant inflation or a new disinflationary era accompanied either by a boom or a bust. After the severe share price declines of many Quality Growth businesses during the current year, and in spite of their more-than-respectable corporate earnings and earnings expectations, it has become easier to make a mistake than to avoid one. It is thus crucial for such investors to allow their portfolio to run its course. Elation to the investor following stock market withdrawals at a time like this will be short-lived and share prices substantially higher when “clarity” returns to markets.

At the heart of this argument lies the question of why Quality Growth businesses, with all the attributes we call the Ten Golden Rules, should suffer price declines equivalent to many high-growth businesses, whose profitability is yet to emerge at some time in the future and whose balance sheets are laden with debt. For such businesses, the sharp rise in government bond yields has inevitably represented, and will continue so to do, an extra cost to the business, one relating to the servicing of their debt. This cost has increased sharply. But can the same argument be put forward for Quality Growth businesses, one of whose leading Golden Rules is an absence or a quasi-absence of net debt?

To dwell on this question is not particularly productive. The fact is that rising bond yields have caused share price declines across the board. As a result, the short-term expectations have it over the long term. The term “perpetuity”, crucial to all Quality Growth companies whose long-term value resides therein, is not currently in use.

But it should be.

Irrespective of important topics such as the future of inflation or whether globalisation is coming to an end and off-shoring replaced through friend-shoring, the Quality Growth investor needs to remind him or herself of why they are invested in this unique asset class in the first place. And the answer is that such investors aim to benefit from sustainable returns over the long term.

If it ain’t broke, don’t fix it.

P. Seilern-Aspang,

30th November, 2022

Any forecasts, opinions, goals, strategies, outlooks and or estimates and expectations or other non-historical commentary contained herein or expressed in this document are based on current forecasts, opinions and or estimates and expectations only, and are considered “forward looking statements”. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to be different from expectations.  Nothing in this newsletter is a recommendation for a particular stock.  The views, forecasts, opinions and or estimates and expectations expressed in this document are a reflection of Seilern Investment Management Ltd’s best judgment as of the date of this communication’s publication, and are subject to change. No responsibility or liability shall be accepted for amending, correcting, or updating any information or forecasts, opinions and or estimates and expectations contained herein.

Please be aware that past performance should not be seen as an indication of future performance. Any financial instrument included in this website could be considered high risk and investors may not get back all of their original investment. The value of any investments and or financial instruments included in this website and the income derived from them may fluctuate and you may not receive back the amount originally invested. In addition stock market fluctuations and currency movements may also affect the value of investments.

This content is not intended for use by U.S. Persons. It may be used by branches or agencies of banks or insurance companies organised and/or regulated under U.S. federal or state law, acting on behalf of or distributing to non-U.S. Persons. This material must not be further distributed to clients of such branches or agencies or to the general public.